Real capital market integration in the EU: How far has it gone? What will the effect of the euro be?

Much effort has been devoted to the study of financial market integration i n Europe. Little is known, however, about real capital market integration - the degree to which plants and equipment move to take advantage of locally high returns. This paper looks at the evidence. An analysis of flows of fo reign direct investment in Europe shows that integration was quite limited in the early 1980s, but has increased considerably since then. Another anal ysis looks at rates of return of a large number of firms. It reveals that c ountry-specific factors play a significant role in explaining corporate ret urns, poem after taking risk into account. This finding is incompatible wit h the CAPM definition of market integration. The view that integration is l imited in Europe is further strengthened when the same approach is carried out for the USA and Canada. Part of the national specificity appears to be related to labour and goods market regulations, which harm firms profitabil ity. If, by introducing more transparency and eliminating currency risk, EM U strengthens competition on the real capital market, one obvious economic benefit will be a more rational and efficient use of capital, but the most important potential consequences are political. Special-interest regulation s of an exclusively national nature will not survive. They will either fall in a wave of internationalist liberalization, or became embedded in 'harmo nized' regulations at the federal level. A reduction in excessive regulator y burdens, notably in the labour market, could lead to substantial and shar ed productivity gains.